The IRS has proposed new regulations (REG-131186-17) that would affect how partnership liabilities are allocated for disguised sale purposes. The proposed regulations would remove changes to long-standing rules on recourse liabilities made in unfavorable temporary regulations issued in 2016 (T.D. 9788), returning taxpayers to the rules in effect prior to the issuance of the temporary regulations.
Although the new proposed rules would not be effective until finalized, the IRS is allowing taxpayers to rely on them retroactively in place of the temporary regulations. In effect, this means the changes to liability allocations in the temporary regulations are obsolete dating back to their original effective date (for transfers that occur on or after Jan. 3, 2017). Taxpayers with transfers made on or after Jan. 3, 2017, can now rely on the original rules under Treas. Reg. Sec. 1.707-5(a)(2). These rules allow taxpayers in certain circumstances to contribute property to a partnership and receive a leveraged distribution without triggering a taxable disguised sale as long as the debt is a recourse liability to the partner under Section 752.
The disguised sale rules under Section 707(a)(2)(B) generally provide that transfers of money or other property between a partner and partnership must be treated as a taxable disguised sale of property in certain circumstances. The presence of liabilities affects the disguised sale rules in two situations: (1) if the partnership assumes a so-called nonqualified liability of the partner, the amount of the liability in excess of the partner’s share of that liability is treated as proceeds of a disguised sale, and (2) if, within 90 days, a partnership makes a debt-financed distribution to a partner that had transferred property to the partnership, the amount of the debt-financed distribution in excess of the partner’s share of the liability incurred by the partnership is treated as proceeds of a disguised sale.
The longstanding rules under Treas. Reg. Sec. 1.707-5(a)(2) provided separate approaches for determining a partner’s share of recourse and nonrecourse liabilities for the disguised sale rules. A partner’s share of recourse liabilities was generally equal to the amount determined pursuant to the general liability allocation rules under Section 752. Because the disguised sale rules only treat a net decrease in a partner’s share of partnership liabilities as disguised sale proceeds, partners that were allocated recourse liabilities under Section 752 were effectively shielded from the disguised sale rules.
The temporary regulations issued in 2016 (the “2016 regulations”) adopted an approach that required partners to treat all partnership liabilities as nonrecourse liabilities for disguised sale purposes, i.e., solely in accordance with the partner’s share of partnership profits. The 2016 regulations also contained rules dealing with “bottom-dollar payment obligations” in which a partner provides a guarantee of a certain amount of outstanding debt in an effort to increase the partner’s basis in the partnership interest. These rules generally provided that bottom-dollar payment obligations are not respected as recourse liabilities under Section 752 and the regulations thereunder.
The newly issued proposed regulations now remove the liability allocation approach for disguised sales contained under the 2016 regulations and reinstate the previous liability allocation rules. However, the new proposed regulations do not affect the changes made to bottom-dollar payment obligations in the 2016 regulations. The change is not totally unexpected. The 2016 regulations were among eight regulations that the IRS identified as burdensome and subject to potential modification or removal in response to President Donald Trump’s Executive Order 13789, which called for the review of all significant tax regulations issued after Jan. 1, 2016.
The new proposed regulations would apply to any transaction that occurs 30 days after the proposed regulations are finalized. However, the IRS and Treasury are permitting a partnership and its partners to apply all the rules in the proposed regulations in lieu of the 2016 regulations to any transaction with respect to which all transfers occur on or after Jan. 3, 2017. Thus, partnerships are not required to use the approach that was set forth in the 2016 regulations.
The removal of the unfavorable 2016 temporary regulations could have a significant impact on the disguised sale analysis for certain leveraged acquisitions and distributions, and in situations in which a partnership assumed a recourse liability of a partner. Given the ability to rely on the proposed regulations retroactively, taxpayers may want to consider whether applying the former regulations to determine a partner’s share of liabilities provides a more favorable result with respect to a disguised sale of property. A different result under the disguised sale rules may entail corresponding changes in computations under other partnership tax provisions, such as Sections 704(b) and 704(c).
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